Thursday, June 7, 2018

Compound Interest is Here to Stay

Grenke v. DNOW Canada ULC 2018 FC 564 Phelan J

This decision is the damages portion of a bifurcated action, following Weatherford Canada Ltd v Corlac Inc 2010 FC 602,, in which Phelan J held the plaintiff Grenke’s 937 patent to be valid and infringed by the defendants. (Weatherford, a licensee of Grenke, has settled, and the names of various parties, including Corlac, have changed through acquisition and otherwise, which is why the case names are so different: [11]-[17]). The patentee elected damages rather than an accounting [2].

In oil production, a “stuffing box” is used to seal the top of an oil well and prevent leakage of the oil as it is being pumped out of the ground. The 937 patent claims a new type of environmentally-friendly seal assembly, which minimizes leakage [18]-[19]. There was substantial regulatory and environmental pressure to minimize leakage, and the patented technology was a game-changer [21], [45]. The decision is quite straightforward, and it is a good example of damages assessment in the context of a simple product, in which the patented technology contributed a major part of the value of the end-product. (This is in contrast to complex products, such as a smartphone, where any single technology contributes only a small part of the overall value.) Perhaps the most legally interesting aspects are that Phelan J allowed full recovery for convoyed sales, refused to grant punitive damages, and granted compound interest.

To begin, Phelan J emphasized the need to use a “broad axe” in assessing damages: while perfect compensation is the goal, the reality of litigation is that perfection can rarely be achieved: [71]-[73]. This point was repeated at a number of instances, though in most cases the inaccuracy in question would be small in any event: [84], [99], [101], [119], [130], [168]

The basic framework is to assess how many sales the patentee lost as a result of the infringing competition, and to calculate lost profits on those sales, and then to assess a reasonable royalty on all the remaining infringing sales. The parties did not really disagree on this framework, or indeed any major conceptual issues, but only on the application to the facts.

Phelan J accepted that market share was appropriately used by the plaintiffs in this case as a proxy for determining the plaintiff’s lost sales [91], [96], pointing out that “This is not a case with a small number of customers. . . which might require “customer-specific” evidence” [97]. Phelan J held on the facts that the appropriate market was “the ‘environmentally friendly stuffing box market’” [105]. There is something of a debate as to whether and when fixed costs can be deducted in calculating profits (see here, here, and here), but in this case the parties apparently agreed that only variable costs should be deducted [115].

Reasonable Royalty
With respect to the reasonable royalty, Phelan J remarked:

[136] In constructing the hypothetical negotiation of the royalty rate, it is important to take into account the realities on the ground. It is particularly relevant that GrenCo had market strength because of its technology and also important is that all the evidence suggests Grenke would have been an unwilling seller, difficult to deal with, and prepared to push the limits of “reasonableness” to the edge (and perhaps over). This all suggests a rate at the upper end of reasonableness. It is somewhat ironic that Grenke would be deemed, under this hypothetical negotiation, to accept any amount of royalty rate given his general intransigence to the point of “going down with his ship” rather than to settle. However, the Court must accept some of the realities in constructing the hypothetical negotiation and resolution.

There is indeed considerable artificiality in constructing a hypothetical negotiation in a case in which it is clear on the facts that the patentee would never have licensed in reality. But recall that a reasonable royalty is only assessed in respect of sales which the patentee would not have made in the real world; if the patentee can prove that it would have made the sale, then it will be entitled to lost profits. Sometimes, this will be because the infringer was selling into a market that the patentee had not entered. In this case, the parties were competing in the same market, and patentee is seeking lost profits on infringing sales that would not have been captured by the patentee, but which would instead have gone to a different competitor with a non-infringing product. That is, for reasons of pre-existing relationships, distribution, etc, if the particular customer had not bought from the defendant, it would have bought from a non-infringing third party. In that case it makes sense for the patentee to accept that since it would not have made the sale in any event, it would be better to allow the infringer to make the sale as a licensee, so that the patentee gets a return in the form of a royalty, rather than losing out altogether. The artificiality arises because it is only with hindsight that we know that the patentee would lose the sale in any event. At the time, it would have made sense for the patentee to fight for the sale, rather than license the defendant, because (unlike the case in which the defendant is selling into a different market), the patentee would rather have the profits on the sale than a royalty, and it can’t license only for those sales it won’t get, because it doesn’t know at the time that it won’t get the sale.

The larger point, perhaps, is that the objective is to assess a royalty which is reasonable in the circumstances, and a hypothetical negotiation is no more than a useful heuristic, which should not be taken too literally if problems arise in applying it. With that all said, I am not suggesting that it is wrong to assess a reasonable royalty “at the upper end of reasonableness” when the patentee was competing in the same market. I don’t have an opinion on that issue. My point is that the hypothetical negotiation framework is not particularly helpful in resolving the issue.

Turning to the calculation itself, the parties both used the “anticipated profits approach,” supplementing this analysis with the “minimum willingness to accept (MWA) versus maximum willingness to pay (MWP)” [135].

The anticipated profits approach supposes that the parties to a hypothetical negotiation, which takes place at the time of first infringement, split the profits they anticipate the infringer will make from the use of the patented technology. As noted by Phelan J, this approach has previously been used in Jay-Lor 2007 FC 358, and AlliedSignal 1998 CanLII 7464, 78 CPR (3d) 129 aff`d (1999) 86 CPR (3d) (FCA). In “A New Framework for Determining Reasonable Royalties in Patent Litigation,” (2016) 68 Florida Law Review 929, Tom Cotter and I argue that instead of anticipated profits, a split of the actual profits should be used. The difference is important only when actual profits are different from the profits that would have been anticipated at the time of first infringement. Despite the name “anticipated profits” approach, I believe that using actual profits would be consistent with Canadian cases. Note that the anticipated profits already relies on actual profits to a large extent. Profits are sales multiplied by profit margin per unit, and the “anticipated” profits approach normally (always, in Canadian cases) uses the actual sales, not anticipated sales, in calculating the “anticipated” profits. We argue that there is no good reason to use actual sales combined with anticipated profit margin. Further, it appears that in AlliedSignal, the calculation did use the actual profits [213]-[214],though it is a bit difficult to tell as the detailed calculations are in a confidential Appendix. (Note that AlliedSignal never used the “anticipated profits” terminology.) Jay-Lor did refer to anticipated profits, but in calculating anticipated profit margin, it appears that actual post-infringement costs (“over the past four years”) were used to assess the profits that would have been anticipated [142]. If that is right, Jay-Lor used an actual profits approach, with an anticipated profits terminology, or, at most, there was no difference between actual and anticipated profits. In this case, the details of the calculation are not discussed, as the parties were largely in agreement, so it is not clear whether actual or anticipated per unit profits were used. In summary then, if there is a case in which anticipated and actual profits are different, it would be open to Canadian courts to use an actual profits methodology, and in my view this would be preferable in principle, for reasons explained in detail in my article with Professor Cotter.

With respect to the MWP versus MWA analysis, Phelan J noted that in Merck v Apotex 2013 FC 751, (blogged here) “the Federal Court indicated that if there were no overlap between the MWA and the MWP, then the reasonable royalty is the MWA. The “minimum” of the MWA must, logically, be the lower end of the range – therefore, the application of Merck FC to this case leads to the conclusion that 8% is a reasonable royalty rate” [143]. Here again, I would suggest that we keep in mind that a reasonable royalty is being assessed only in respect of sales which the patentee would not have captured. In such circumstances, the patentee’s MWA will be its marginal cost, normally zero, because if the negotiation breaks down, the patentee will not make the sale itself, and so will not get any return at all. If the MWA is higher than the MWP, it must be that there was a conceptual error in assessing the MWA (assuming the patented technology is actually valuable, not detrimental, as was clearly true in this case). The details of the assessment of the MWA was not described. However, the MWP / MWA analysis gave much the same result as the anticipated profits analysis.

In US law, the most commonly used approach to assessing a reasonable royalty is to look to comparable licences. In this case, the defendants suggested that lower rates that had been negotiated in respect of the same technology by Weatherford should be used. Phelan J rejected this, correctly in my view, noting that the deal included cross-licensing which would have depressed the rates.

Phelan J also allowed recovery of lost profits for convoyed sales, on the basis of but for causation, without any further restriction:

[163] If compensation is not provided for such add-on items, then the patentee is not being put in the position that they would have been in but-for the infringement (resulting in less than perfect compensation). If the Plaintiffs can show, on a balance of probabilities, that such sales would have been made by the Plaintiffs in the but-for world, then in my view this is a loss for which they should be compensated. This approach is consistent with the limited Canadian case law on the topic, and I would reject the requirement suggested by the Defendants that such convoyed sales must have no function independent of the patented object.

In my view, Phelan J’s conclusion is sound for the reasons he gives. If the convoyed sales are reasonably foreseeable from the sale of the patented technology, as was clearly the case here, then the patentee would face a choice between charging a higher price for the patented goods, and losing some sales and convoyed sales, or charging a lower price for the patented good, in anticipation of profits from convoyed sales. These are just different strategies for realizing the value of the patented technology, and the damages award should not turn on which marketing strategy was chosen.

Punitive Damages
The plaintiff sought punitive damages. Phelan J noted that:

[186] At the liability phase of this action, the Court found that the Defendants:
a) intentionally set out to create a product which they knew or ought to have known would infringe the Patent;
b) have used a stuffing box design which is the same as the Grenke design, and profited from the sale of the infringing articles over a 10 year span (until enjoined by this Court from further infringement);
c) were considered by this Court to have been unjustified and egregious; and
d) had denied infringement of the Patent, yet at the same time claimed ownership in the Patent and argued that the Plaintiffs had in fact infringed their patent rights.

Phelan J refused to award punitive damages, emphasizing that “patent infringement alone, even knowing infringement, is not sufficient to ground an award of punitive damages,” [185] (citing Bauer Hockey 2014 FCA 158 [29]), and similarly, “there must be something more than knowing infringement to support an award of punitive damages”[189]. The various allegations regarding infringement and validity were considered part of the “brawl” over rights in the technology. No doubt this can be distinguished on the facts from Martineau J’s Eurocopter decision (blogged here), but it does evince the traditional reluctance of the Canadian courts to award punitive damages.

The Federal Court has historically been reluctant to grant compound pre-judgment interest, in part for the very good reason that the relevant statutes relating specifically to interest did not allow compound interest: see Federal Courts Act, s 36(4)(b), as noted by Phelan J at [205] (and the discussion here). There has been a recent and welcome trend to granting compound interest nonetheless, based not on the interest provisions, but on the basis that the loss is recoverable as an element of compensation, under s 55(1). The rationale is that in reality, a party with more money in its pocket will put that money to work, and reinvest the profits, which will also go to work, and compound interest is therefore required to provide full compensation. That is the approach taken by Phelan J at [193], [209] following Zinn J in Eli Lilly / cefaclor, 2014 FC 1254 (discussed here). Phelan J stated that “I concur with Justice Zinn’s comments that in today’s world, compound interest is an accepted form of redress” [194].

An interesting point arises from the approach of awarding compound interest on the basis of s 55(1). Phelan J began his discussion of interest by noting that the award of interest under s 36 of the Federal Courts Act is subject to judicial discretion to disallow interest under s 36(5), which discretion is “to assist the court in controlling the litigation process and to avoid inappropriate compensation” [191], quoting Apotex v Merck 2006 FCA 323 [140]. Phelan J also stated that compound interest was also awarded “[a]s a matter of discretion taking into account the equities and the conduct of the Defendants” [211]. But s 55(1) is normally understood as entitling the patentee to its legal damages, with only equitable remedies, such as an accounting, being subject to discretion. If compound interest is awarded as compensation under s 55(1), can it be discretionary? I’m not sure of the answer to this question, particularly in light of the argument for allowing the court to use its discretion in order to control the litigation process. The question did not arise in this case, as Phelan J did not exercise his discretion to disallow compound interest for the period for which it was claimed, but it presents something of a conundrum. No doubt the best solution would be updated interest provisions in the Federal Court Act, but there is little prospect of that happening, and I expect the issue will have to be resolved judicially.

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